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Making the Bull Case for Financials Courtesy of QE3

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The biggest impact of QE3 on the banks is the promised stability it offers the housing market. This translates to improved stability for banks that are holding US mortgages.

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The financial services sector has been sitting in its time-out chair for at least four years now. The sector has really never recovered to the pre-2008 financial crisis levels. Any optimism that it might recover to those levels soon is probably misplaced. However, the sector has some nice room to still run over the long haul, and I'll make that case below.

We know the two biggest reasons financial services stocks are still so depressed compared to 2007 levels: (1) given the new rules that they are forced to play by, they will not get back to their pre-2008 earnings levels any time soon, and (2) many banks continue to carry "problem" assets on their books that make valuation difficult to gauge.

Let's review these two areas before we make our bull case for financials. Wall Street's pre-2008 earnings levels are a distant memory. These firms will never again be allowed to use the leverage they used or make the risky bets with capital that they once made. And rightly so, as we saw the outcome of risk investment capital gone wild during the financial crisis.

As a result, the earnings potential of these firms is now capped. On top of that, with these firms taking less risk, they have lower reward potential (read: lower reward potential as lower growth potential). With lower growth potential, the industry will see a lower PE ratio. That is just a basic tenet of investing!

Regarding the second problem for financial services, the largest banks still carry many toxic assets on their books – mostly in the form of US mortgages that have been packaged into fixed income securities. These firms have had to raise capital to buttress their balance sheets because of the losses on these toxic assets. It is difficult for investors to put a size on the problem on the books of these largest banks because the insight to the exact holdings is unclear. This uncertainty just continues to weigh down on the valuations of many of the largest banks.

Despite these continued challenges for financial services companies, I can see a light at the end of the tunnel -- and it is not a train!

QE3 is now officially announced by the Fed. QE3 will keep interest rates for mortgages low for the foreseeable future. In fact, this is just a general continuation of the trend to keep interest rates low across the board.

At first glance, lower interest rates seem like a problem for financial services companies. Lower interest rates promote tighter and lower Net Interest Margins (or NIM). NIM is the primary source of revenue for most financial services companies. Think of NIM as the business model of loaning money-borrowers at one rate with your source for loaning that money at a lower rate.

The continued compression on NIM will hurt financial services companies over the short term. These firms that rely on NIM will certainly continue to feel pressure on their bottom lines in the short run, but I fully expect these firms to find new fees to charge clients. I don't think these firms have any choice in the matter. Prolonged compression of the revenue associated with NIM through 2015 will not be acceptable to shareholders. So, expect many financial services firms to generate new revenue streams through new fees they can charge clients. I expect that every firm has some pricing power in the margins. And I guarantee that every large financial services company has been discussing the potential for raising prices and fees. It will not be a big boost, but it will be something.

To me, the biggest impact of QE3 on the banks is the promised stability it offers to the housing market. Continued lower mortgage rates will help promote more re-financing and help to support a potential floor in housing prices. Even if housing prices might decline further, the decline will certainly be slowed by the support of lower mortgage rates from the Fed.

Stability in the housing market and increased refinancing should translate to improved stability for the banks that are holding US mortgages. That kind of stability might help to clear away some of the uncertainty related to the balance sheets of the largest banks. Or, at the very least, it should help buttress those banks and help them continue to "earn their way" to a healthier balance sheet. If these firms can get their balance sheets in order, then that will equate to more shareholder value – either in an improved stock price or in some release of capital that is returned to shareholders.

My firm is long the Financial Select Sector SPDR (XLF). We are also long Bank of America (BAC). Both of these investments stand to benefit in the long run from improved stability in the housing market – even if the short-term pressure on NIM might hurt some. We plan to stay long both of these positions, and any pullback in JPMorgan (JPM) we would view as a gift, given that it is best-in-breed in this sector. And, as usual, we are hedged in every one of these positions.
No positions in stocks mentioned.
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